I read an article this weekend that made me angry. It’s titled “TurboTax, H&R Block spend big bucks lobbying for us to keep doing our own taxes.” The basic premise of the article is that Congress has been working to develop a method to reduce the time and frustration of filing tax returns. This tax reform plan would have the IRS pre-populate tax returns for a vast majority of tax filing Americans. The IRS is able to do this because they usually already have a bunch of your information. Companies report the wages that they pay you to the IRS. In addition, your brokerage provider will report any investment earnings you have to the IRS. The IRS would simply use this information, populate your tax return, and mail it to you come tax time.

You could simply review your pre-populated tax return, sign it, and send it back if there are no errors. Wouldn’t it be a great tax reform bill that made this into law? On top of that, the whole process would be free. Tens of millions of Americans would be able to submit tax returns with no time and no money expended. The overall gain to the US economy would be enormous, as people would no longer have to waste time and effort trying to figure out a complicated tax code which no one understands. Unfortunately, two large tax filing companies spent millions of dollars lobbying to guarantee that the bill didn’t pass.

Three Pillars of Tax Reform We can All Agree On

As many people as possible should be allowed to file their tax returns for free and without tax filing assistance. This is a net gain for everyone. Those who are poor can’t afford the money, and those who are high income earners can’t afford the time.

If the IRS already has the information, it’s better to simply supply the completed form to people, so they don’t have to spend extra time and effort making sure they don’t make a mistake. This reduces worry, frustration, and endless hours sorting through the tax code by regular people.

Reducing the role of for-profit corporations in filing taxes will only benefit the economy. Filing taxes is a necessity in our modern world. However, time and money spent on filing taxes is not spent on improving our infrastructure, researching novel technologies, or providing charity to those in need. Tax reform that focuses on minimizing this aspect of the economy will simply reallocate the resources and people currently in those industries to more productive uses.

If you found value in this content, please consider sharing it so that others may find it as well.

Comment if you have any thoughts or questions, so that we may all benefit from your perspective.

The stock market reached an all-time high this week, with the S&P 500 index surpassing 2400 for the first time. There isn’t anything in particular about an all-time high that signals an impending stock market crash. Markets achieve new highs all the time. Instead, the relationship between the value and the price of the stock market is the critical factor. When an undervalued market makes new highs, there is no need for concern. However, an overvalued market making new highs is more concerning. Currently, the stock market is not only overvalued but in the midst of a major bubble. This confluence of factors has led me to prepare my portfolio for an impending stock market crash.

The Everything Bubble

Last year, I discussed the warning signs indicating a bubble in the bond markets. That bubble still exists. This is ever more worrying with the existence of a current stock market bubble as well. It is important to carefully consider the difference between a bubble and simple overvaluation in the stock market. One difference is a matter of scale. Overvaluation exists in both an overvalued and a bubble stock market. However, a bubble exhibits much higher levels of overvaluation. Once bubble prices are reached, there usually ceases to be a tangible connection between prices paid and the underlying value of cash flows.

Bubble Warning Signs – Billion Dollar Companies with No Profits

During the Dot Com bubble of the late 1990’s and 2000, many technology stocks were valued at billions of dollars while not producing a profit. This irrational exuberance is an easy example of behavior that occurs in a bubble. Snap Inc had it’s initial public offering this past week and is now valued at $28.36 Billion. Snapchat, the popular social media app, is the primary asset of Snap Inc. Snap is a modern day example of a bubble stock. The company makes no profit and their public disclosure document states that they may never become profitable. For reference here are two relevant quotes from their filing with the SEC:

“We began commercial operations in 2011 and for all of our history we have experience net losses and negative cash flows from operations.“

“We have incurred operating losses in the past, expect to incur operating losses in the future, and may never achieve or maintain profitability.”

Snap Inc lost $514.6 million in 2016. All of this money comes out of the pocket of the investors in the company. That’s part of the reason why companies like this go public. They are able to sell shares to the public at overvalued prices and use it to fund continuing operations of the company.

Your goal as an investor is to purchase as much profit as possible for the lowest possible price. Based upon that criterion how much is a company like Snap Inc worth? You want to buy profits, but Snap Inc doesn’t make any profit. Therefore, for an investor who chooses to invest and not speculate, Snap is worth $0. By the company’s own admission, they have only ever lost money and may never become profitable. This one company alone is therefore 28.36 billion dollars overvalued.

The stock market grows into a bubble over a long period of increasing valuations. It would be predictable when this bubble might be about to burst. In the same way, a stock market bubble presents warning signs for prudent investors.

Irrational exuberance can also be evident when profitable companies are valued well above the true value of your current and future cash flows. Netflix is today’s modern example. Last year, Netflix earned $187 million in profit. Based upon the 439 million diluted shares; Netflix earned $0.43 per share in 2016. On Friday, March 3rd, 2017 Netflix traded at $139.14. A simple trailing 12 months price to earnings ratio would be 323. While trailing P/E ratio’s are not sufficient information as a valuation metric, they are useful as shorthand indicators of value. A reasonable valuation is typically a P/E ratio of between ten and twenty. Netflix would have to drop in price by 94% to $8.61 per share to even reach the high end of that valuation range.

Alternative Valuation Metrics – Profits Don’t Matter

It would be reasonable to wonder why investors are willing to pay such an extremely high price for a small stream of profits. As it happens, this is quite a common occurrence during stock market bubbles. Investors begin to use alternative metrics to value potential investments. One of the alternative metrics which has become common during this bubble is the use of revenue growth to justify higher stock prices. Amazon is another example which I previously discussed. Revenue growth without earnings growth is useless for an investor. Only earnings are able to be paid as dividends. Netflix has grown revenue from $4.37 billion in 2013 to $8.83 billion in 2016. This represents an annual revenue growth rate of over 26%. Unfortunately for Netflix investors, the earnings growth rate has been much lower. Earnings per share have only grown at a rate of 12% over that time frame.

A common feature of great businesses is the ability to increase earnings at a faster rate than revenue. This effect is due to leverage inherent in the business as limited fixed expenses are spread out across larger revenues. Netflix does not operate under such a favorable business model. Netflix’s expenses increase proportionally with their revenues because they pay for content each time it’s viewed by their users. Netflix doesn’t have power in the relationship with content providers. Netflix must constantly pay more for it’s content as it’s user base grows.

The market assumes that eventually the quickly growing revenues at Netflix will start to lead to large growing earnings. The market will be wrong in this regard. Investors holding Netflix during a stock market crash, will likely lose a lot of money from current prices. Growth companies with limited earnings are popular during raging bull markets, but drop more during a crash.

Bubble Warning Signs – Stock Index Valuations in excess of National Production

Warren Buffett has spoken a few times about his favorite measure to determine whether the stock market as a whole is overvalued. His preferred measure is the total value of all public companies as a percentage of the entire country’s production. This valuation ratio is known as Market Cap to GNP. This ratio is useful in part because these public companies produce much of the country’s production. If the ratio is high, then the market is valuing each dollar of production much higher than usual. If the ratio is low, then the market is valuing each dollar of production much lower than normal. As things stand today, the Market Cap to GNP ratio is at one of it’s highest levels ever, eclipsed only by the Dot Com bubble peaks in 2000. We are already well in excess of the valuation levels of the 2007 market bubble.

In 2001, Warren Buffett indicated that the Market Cap to GNP ratio should have warned investors about the coming crash during the Dot Com Bubble. If you review the chart of the current ratio, it’s impossible to ignore the similarities between current valuations and past bubbles. You should manage your portfolio accordingly.

Valuations predict future returns – The future is bleak

While it is useful to know that high market valuations are indicative of a bubble, it is much more useful if you can quantify the expected rate of return at current valuations. Dr. John Hussman, an investment portfolio manager, who predicted the stock market crashes of both 2000 and 2007, has done just that. His focus has been on developing correlations between past stock valuations and future expected returns. He agrees with Warren Buffett that Market Cap to GNP correlates well with future returns. However, his preferred measure is non-financial market cap to non-financial gross value added. This ratio provides an even higher correlation to future market returns than Market Cap to GNP. These ratios have continued to have a strong correlation even through the recent Dot Com stock market crash.

Hussman’s current prediction is that current market prices project an S&P 500 total return of less than 1% annually for the next 12 years. With the dividend yield of the S&P 500 approximately 2%, the S&P 500 would be lower than it’s current value 12 years from now. He also projects an intermittent stock market crash of at least 50-60%. This is the crash potential which is now embedded within current stock prices. Are you prepared with your investing plan to prosper amidst a stock market crash of this magnitude?

Stock Market Crash Warnings – The End of Speculation

Car companies prepare for a crash by crash testing their cars. Investors should prepare their portfolios for a stock market crash. Is your portfolio crash proof?

Stock market bubbles by definition are not rational. They are established through rank speculation which bids prices up to levels without any connection to underlying earnings. However, high valuations alone are insufficient to predict short-term changes in prices. As Benjamin Graham observed many years ago, valuations are only useful as long-term predictors of stock returns. In the short term, stocks can go from overvalued to even more overvalued. This phenomena is necessary for bubbles to develop.

Behavioral psychology is much more useful in predicting short-term outcomes. Greed and fear are common emotions exhibited through the course of the market cycle. As bubbles reach their top, greed is highly present. Speculators extend speculation due to recent success. Their greed fuels motivation to make even more money. As markets bottom, it is the fear in the markets of further losses which lead to investors selling their shares when they shouldn’t. Currently, greed and signs of irrational exuberance are at major highs associated with other market peaks throughout history.

Investing Pendulum – Value vs Momentum

In addition, stock traders tend to follow strategies built upon following momentum. Momentum strategies are quite different from the fundamental analysis strategies which I discuss here at DIY Investing. Instead of focusing on intrinsic qualities of a business, momentum traders use changes in price as their guide. This strategy is usually quite successful through the majority of bull markets and bear markets. Traders will buy when prices have started increasing and sell when they’ve started decreasing. The problem is that the strategy performs poorly during market times of great change. It’s not possible for a momentum trader to predict or prepare for a stock crash, as they only receive their signals based upon past prices. Meanwhile, fundamental analysis clearly shows us that stocks are overvalued at this time.

Value investors are likely to reduce their exposure to stocks as valuations substantially exceed their historical norms. Meanwhile, momentum traders will be going all-in as stocks continue to rise in price. For every stock sold by a seller, there is always an equivalent buyer. Therefore, by definition changes in stock price only occur as one side of the buy/sell arrangement is more enthusiastic than the other. Eventually, there are not enough value investors willing to sell their stocks to the momentum investors. As this happens, most market transactions will take place simply between two traders. This can continue only while a greater fool is willing to take on the risk of market losses.

Crash Catalysts

The actual stock market crash can be triggered by any number of events. It’s pointless to try and predict the actual catalyst. However, the presence of obscene market valuations creates the conditions by which a crash is likely to occur. Catalyst events usually indicate increased uncertainty about the future of market returns. This increased uncertainty reduces the inclination for traders to take risk. As this shift occurs from risk taking to risk mitigation, there is a greater tendency to sell stock holdings. A crash occurs when there is a large enthusiasm to sell stocks, but prices are at a valuation high enough to discourage investors from buying them. Stock market prices then have to drop significantly to reach the point at which value investors are once again willing to accept the risk of the market.

The Coming Stock Market Crash

I have become increasingly concerned with the current valuation levels of stocks. I have backed up my concern with action. Over the past few weeks, I have substantially reduced my exposure to the public stock markets. I’ve liquidated all of my ownership in mutual funds. I’ve also sold off a substantial portion of my ownership position in individual businesses as I work to build up my cash position. Individually, these businesses have increased in price to a large degree over the preceding months, each reaching a point of overvaluation. Currently, I have a portfolio composition of approximately 80% cash and 20% stocks. All of this has been done in an effort to guard against what I view as the increasingly bleak risk/return of stocks.

I am unable to predict the exact timing or magnitude of a stock market crash. This is a feat which I consider impossible for anyone to accomplish. What I am capable of doing, is adjusting the potential risks and rewards of my portfolio to be as favorable as possible. During current market conditions, cash has become a preferred holding over stocks. Stocks represent likely returns of less than 1% annually, with the possibility of large interim losses. Meanwhile, cash represents guaranteed returns of 1% annually without the possibility of large interim losses. Cash also represents the option to make future investments at better prices.

Investors would do well to learn from Warren Buffett’s actions in 2008. He saved up large amounts of cash in the years prior. This allowed him to invest large sums of money in distressed companies as super low prices. You can do the same thing if you are prepared and build up cash in advance. Preparation is only useful when performed in advance of a crash or emergency.

My prediction

This past week the stock market hit 2400. I predict the S&P 500 index will hit 1500 before it hits 3000.

A stock market crash will come eventually. Based upon current valuations, it would be completely normal for the S&P 500 to decline from 2400 this week to at least 1200 or lower. Drops of 50% are normal to occur in every investing life at least two or three times. Declines of 10% or 33% are even more common.

I encourage each of you to take the time and review your portfolio strategy. If you don’t have a set portfolio strategy, you should consider crafting one. I hope to help you develop the principles and guidelines to successfully manage your own portfolio. For now, remember Warren Buffett’s two rules of investing:

Never lose money.

Never forget rule #1.

What are your thoughts on the current stock valuations? How are you preparing for a possible stock market crash? Share your thoughts in the comments below.

Donald Trump becomes president today, January 20th, 2017. Some of you are happy with this outcome, and others of you are dreading the coming four years. Many of you across both groups might be unsure what Donald Trump’s new presidency means for your investment strategy. No one can predict the day-by-day changes in the stock market, but I can give you some advice on how to position your investments. Below, I discuss ways that your investment thesis may change after Donald Trump’s inauguration.

Positive Investment Outlook of a Donald Trump Presidency

Donald Trump has outlined a few key aspects of policy which will be beneficial to businesses in the United States. It is important to remember that the goal of your investment thesis should be to buy the maximum amount of risk-adjusted profit. Therefore, any policy that leads to greater profitability for business in the United States will likely improve investment performance.

Reduced Corporate Taxes

The policy of President Trump which is most favorable to a positive investment outlook is his stated goal to reduce corporate taxes. The current corporate tax rate of 35% is one of the highest in the world. A high corporate tax rate makes investment in the United States less favorable for companies. Any reduction in the effective corporate tax rate in the United States will lead to greater profits for US corporations, all else equal. Thus, greater profits for US corporations means a greater after-tax return for investors in US and foreign corporations that do business in the United States. If Donald Trump is successful in reducing the corporate tax rate from 35% to 15%, this would be a substantial windfall for investors.

Reduced Government Regulation

A second policy of President Trump which favors a positive investment outlook is his goal of reducing government regulation. Government regulations are a useful tool by which society is able to ensure that negative externalities are taken into account in business decisions. However, government regulations once put in place, are seldom revisited or reduced in scope. This means that over time, they tend to grow and lead to inefficiencies which can reduce the ability for business to operate effectively. Reducing government regulations will reduce costs on new businesses and startups as they try to compete in the marketplace.

Increased Infrastructure Spending

Donald Trump also wants to increase infrastructure spending in the United States. His stated goal is to both repair aging infrastructure and provide additional jobs. Additional government spending tends to provide a short-term stimulus to the economy. As the economy improves, businesses not directly impacted by the spending will see benefits to profitability as well. In addition, a better, safer, and more efficient country infrastructure benefits both workers and businesses. Infrastructure acts as a “free” boost to the ability for US entrepreneurs to take advantage of business opportunities. For example, a truck driver is able to deliver his cargo faster and more efficiently with the existence of the highway system. When the highways are in good condition, there is less chance of accidents which could delay deliveries.

When Donald Trump becomes President he will have considerable influence over the world’s largest economy. Will his effect be positive or negative on your investment thesis?

Negative Investment Outlook of a Donald Trump Presidency

Not all of Donald Trump’s policy proposals will benefit investors. In fact, Trump’s election as president could negatively impact short-term investment performance regardless of whether he implements some of his proposals. One of the key reasons for this, is that Donald Trump’s election has created a shroud of uncertainty and unrest within the United States. Uncertainty leads to reduced or cautious business investment and consumer spending. Reduced business investment and consumer spending are key factors which could lead towards a recession. For this reason, investments in general, dislike uncertainty.

Fear

Fear among minority populations of the United States is one major aspect of the uncertainty that Donald Trump has created. Donald Trump spoke with a large amount of negative rhetoric targeting those of specific ethnicity and faith as a means of building support for his election. Due to this behavior, there are many US citizens who now fear what will come in the next few years. Will they be targeted with policies that take away their rights, or livelihoods? Are they safe within their own borders? Accordingly, these fears will have a negative impact on the US economy whether or not the fears are proven true. Uncertainty and fear are feelings which prevent or reduce the ability of a group to start, expand, or grow business. We are all interconnected in the economy. Therefore, reduced economic growth in some areas, will lead to a reduced economic outcome for everyone.

Reduced Free Trade

Donald Trump plans to reject, reduce, or eliminate future and current free trade agreements. This is perhaps the most damaging policy, in terms of investment outlook, of our new president. Free trade, or trade without tariffs or protectionist barriers is an incredibly positive force for business performance. Arguably, free trade allows businesses to take advantage of each countries particular competitive advantages. The United States with high design and technical expertise is an example of a good place to design new products. Meanwhile, Germany with high manufacturing expertise is a great place to build products. Alternatively, China with low labor costs is a good place to build products. Businesses that can leverage low production costs in one country with high sale prices in another country are more efficient and profitable. If you’re an investor, you want the businesses that you own to operate in the most efficient and profitable manner possible.

However, Donald Trump’s plan to use tariffs will reduce free trade. Import taxes discourage the importation of goods. Essentially, you’re putting in place an artificial barrier to the best economic action of a business. Artificial price controls of any form are always inefficient and create economic dead loss. Yet, Donald Trump has made it his goal through campaign rhetoric to ‘bring back jobs’ and ‘protect the US worker.’ He hopes to do so by implementing policies that will reduce free trade. However, reducing free trade will not only reduce corporate profits and the performance of your investments. It will also reduce the international competitiveness of US companies and US workers. This will, over time, lead to lower wages and greater unemployment for the US worker. In other words, President Trump’s plan will backfire.

What changes should you make to your investments?

President Donald Trump will make policy changes that will affect the profitability of some businesses in the short-term. Moreover, there is a chance that some of his policies will affect the long-term performance of your investments. However, it is impossible to predict this outcome, either positive or negative in advance. We can’t know which policies Trump will be successful in implementing. Although we can predict some of the first-order effects of these policies, it is also hard to predict the second and third order effects that they will have. This is especially true regarding free trade agreements.

Remember history. The United States has had all manner of presidents. We have had popular presidents and hated presidents. We’ve had rich and poor presidents. We’ve had good and bad presidents. In addition, the political experience of our presidents has been quite diverse. However, historically the stock market has continued to provide annual returns of 10% or more over the long-term. These returns are consistent through both Democrat and Republican presidencies. Ultimately, the returns have continued through two world wars, a civil war, great depression, and great recession.

All of this is to say that you can’t predict the short-term performance of your investments. The four-year time span of a presidency is definitely short-term. The value and price of your investments can fluctuate substantially over that time period. Ten years is the minimum I would consider long-term investing. Over this time frame, the fundamentals of the businesses that you own will have the greatest effect on your investment performance.

Final Advice

The best advice I can give you is to simply ignore the election of Donald Trump as a non-event in your investing outlook. Perform fundamental analysis of the profit potential of the businesses that you want to invest in. Determine the likely outcome of their future cash flows under worst and best case scenarios. Analyze what risks might cause your projections to be wrong. Invest with a margin of safety. Hold for the long-term. If you do these things, then your investment performance will be satisfactory regardless of who is president. You can’t predict what policies Donald Trump will actually implement or how they will turn out, so don’t worry about it. Let the leaders of the companies you own worry about it. Their job is to figure it out and make you money.

The efficient market hypothesis (EMH) states that it is impossible to outperform or beat the market because stocks and bonds are always priced at fair value. Fair value is determined by the market incorporating all publicly available about a company into it’s stock price. As an investor, you should determine whether or not you believe the efficient market hypothesis to be true. Your decision regarding the efficient market hypothesis will drastically affect how you should approach investing. In this post, I present you with a case study comparing Amazon and Berkshire Hathaway. My goal is to allow you to make your own decision concerning the efficiency of the market.

Efficient Market Hypothesis Assumptions

This means that investors seek to maximize their risk-adjusted returns when investing. For this assumption to hold true, investors must always make their investment decisions based upon logic or data to determine what each individual company is worth. Rational investors do not allow emotions, such as fear or greed, to sway their investing decisions.

On average, the total investing population is correct in it’s valuation of a companies. (Based upon Market Capitalization)

In this case, even if every single person is individually wrong in their valuation of what a company is worth, the final market price is the correct value for the company because it averages out the mistakes of individuals.

The current value of stock prices incorporates all known public information about a company.

The additional assumptions created by this statement are that most, if not all, investors have access to this public information, know how to access it, and does so prior to investing.

Stock prices will quickly, or immediately, update any new information released publicly about a company.

The market must incorporate new information in order to ensure that it remains efficient. If the market does not incorporate new information then it will lose it’s efficiency simply whenever new information is released. The efficient market hypothesis does allow for the fact that temporary changes will occur as the stock price adjusts to the new proper valuation due to news releases.

Current Profits Comparison

Berkshire Hathaway’s profits are in the billions while Amazon’s profits were consistently less than $1 billion. Amazon also posted losses in two of the past five years, while Berkshire Hathaway has posted steadily rising profits each of the last 5 years. For illustration purposes, I have created a chart of the profit and loss figures for the two companies.

A large discrepancy exists between the profits of Amazon and Berkshire Hathaway. Berkshire Hathaway is a large company with very diverse sources of profits. Berkshire owns over 50 operating companies. Amazon makes much less profit and is also receives revenue from fewer sources.

Future Profits Comparison

Remember, the market is saying that these two companies are worth approximately the same amount right now. The market value of a company is based upon future performance, not what it has done in the past. If the efficient market hypothesis is true, there should be no difference in the performance of an investor who invests $10,000 in Amazon vs someone who invests $10,000 in Berkshire Hathaway. Let’s assume that the profit estimates for Amazon come true for the next 5 years. Meanwhile, Berkshire Hathaway merely matches it’s previous 5 years of growth. The result is shown below.

If the efficient market hypothesis is correct, then there should be no difference in an investor’s performance by choosing either Amazon or Berkshire Hathaway. However, the difference in profit between the two companies is large and will likely grow over time. Projected profits are shown to the right of the red line.

Amazon ends with $4.4 billion in annual profit in 2020,while Berkshire Hathaway ends up with $44.5 billion in annual profit. Let us assume both companies end the period valued at fair value. We’ll state that a P/E ratio of 15 is fair value in this example.

Amazon’s value in 2020 = $66 billion

Berkshire Hathaway’s value in 2020 = $667.5 billion

Investor performance

Based upon these numbers, if investor A put $10,000 into Amazon today, while investor B put $10,000 into Berkshire Hathaway, a large difference would result. Investor A would have $1,853.93, while investor B would have $18,287.67. This leaves investor B with almost ten times as much money as investor A. The efficient market hypothesis would suggest that this outcome is not possible.

There are a few possible conclusions. The first and simplest solution is that the efficient market hypothesis is wrong. It is possible to outperform the market by proper selection of stocks via fundamental analysis. I believe this to be the most credible answer.

A different conclusion could be that Amazon will maintain a growth rate much larger than Berkshire Hathaway for longer than 5 years. If we were to accept the 49.4% growth rate and let Amazon’s earnings continue to grow at that rate, they would eventually surpass Berkshire Hathaway’s earnings. This is a possible outcome. If this were to happen, then the market could be efficiently valuing Amazon and Berkshire Hathaway. It’s up to you to determine whether you think that is the likely outcome.

Implications of the Efficient Market Hypothesis for Investors

If you believe the efficient market hypothesis to be true, then your best action as an investor is to invest solely in index funds that match the market. Under the efficient market hypothesis, it is impossible to outperform the market, so you will achieve maximum risk-adjusted returns by simply owning the entire market. You can use index funds or index ETFs to achieve this goal.

If you believe the efficient market hypothesis is not true, then your best action is less clear. It can still be rational to invest in index funds. Even if the market is not efficient, you could still capture average market returns without much effort. This can be a very positive outcome. However, if you wanted to outperform the market, then you could follow a number of value-based strategies to increase your odds of success. I will cover these strategies in depth. I believe it is possible for an individual to either beat the market or match the market with less risk than the market as a whole.

Do you think the market is efficient? Share your thoughts below in the comments.

If you found this information useful or helpful consider sharing this article with your friends. You can use one of our social buttons or send them the link directly.

The world is currently experiencing another bubble, but it’s not in stocks this time. A giant bond bubble is forming as the world watches without concern. The media sees the same signs that are available to everyone, yet they have not pointed out any of the problems that are going to arise. This bond bubble will likely cause another great depression much worse than the recession which we just experienced.

Current Bond Bubble

What if I told you that I wanted to borrow $1,000 from you for the next ten years, but instead of paying you interest, you would have to pay me interest? Would you do it?

What if you could make an investment that guaranteed you to lose money? Would you do it?

If the answer is NO to either of those questions, then you should be very careful buying or owning bonds right now. Those situations are exactly what is occurring in the government bond market. The latest sign of the bond bubble arose when today for the first time ever, the German Government’s 10 year bond, the Bund, started selling for negative interest rates. This means that people are now willing to pay the German government for the privilege to give them money. Does that make any sense at all? The irrationality which has been occurring in the bond markets as interest rates have dropped to zero or negative has been astounding.

Expected Results

Just as this bubble grew too big and eventually burst, so too will the current bond bubble. Government debts will eventually grow too large to be properly financed and interest rates will rise. This will likely create a cascading effect where interest rates rise throughout the world and government debt is no longer a safe haven for money.

Nothing good can come of this situation. Savers are now in a situation where they have no incentive to save money as they can’t earn interest without taking risks in the market. Meanwhile, governments have no reason to spend money wisely as they can cheaply issue debt at record low or negative interest rates. Bond owners WILL lose money. It is no longer a question of if, but a question of when.

Negative interest rates on debt are not sustainable and will lead to catastrophic effects if policy makers do not carefully handle the situation and focus on fixing it quickly. No matter what happens the results from here will be bad. Millions and billions of people will lose money if they are holding bonds. One of two outcomes can be expected. If the bond bubble bursts it will lead to a massive crash in the bond market. Alternatively, bond holders will spend years and perhaps decades slowly but surely losing the value of their money as the situation corrects.

The Coming Crash and the 2nd Great Depression

The crash caused by the bond bubble bursting would be far worse than the great recession which we just went through beginning in 2008. In the great recession the US stock market fell by 57% from October 2007 to March 2009. This represented trillions of dollars of investment value wiped out in the span of a year and a half. However, the global bond market is nearly twice the size of the global stock market. In 2010, global stocks represented $54 trillion in value, while global bonds represented $93 trillion. By 2014, the global bond market value surpassed the $100 trillion mark. The global bond market would only need to fall 33% in value to match the losses seen by the stock market crash of 2008. Meanwhile, if bonds crashed 57% like stocks did, then you’re looking at a loss in value approximately equal to the entire global stock market.

Do you own large amounts of bonds? Are you prepared in case the bond bubble bursts? How do you think this situation will resolve itself?

Share your thoughts in the comments below and if you found this article useful share it with your friends and family.

Disclaimer

All investments entail risks. The value of shares and investments and the income derived from them can go down and up. Investors may not get back the amount they invested. Past performance is not a guide for future performance. All information, tools, and resources presented on this site are for informational and educational use only. Please refer to the Terms of Service for more information.